The Great Wall of private equity

PE structure is diversifying in spite of regulation and foreign-capital restrictions

By

ChenHuiying

BEIJING (Caixin Online) -- Private equity (PE) funds in China have been developing at an unprecedented rate, and are now a hot topic in the country's capital market.

PE in China used to be a simple story of investing and exiting for quick capital gain. Over the course of years, however, it has evolved into a multilayered process of financing, regulation, investment, and exiting. Regulators, local governments, state-owned enterprises, and high net worth individuals now all play roles in the industry.

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Diversified structure

In September 2009, CCB International Holdings Ltd. turned its attention to the domestic market by raising 2.6 billion yuan ($381 million) through a health-care industry investment fund. At the end of 2009, Tianjin Shipping Industry Fund similarly raised 2.85 billion yuan. In January 2010, CITIC Mianyang Private Equity Fund announced it had become the largest yuan-denominated fund in China by raising 9 billion yuan.

Data from the Zero2IPO Research Center shows that yuan-denominated funds have grown quickly and have come to dominate the market in terms of the total amount of new funds raised. Moreover, several global PE fund companies hope to establish yuan funds.

Large-scale yuan financing by PE has formed into a diversified structure. State-controlled institutions such as the National Social Security Fund have been authorized by regulators to engage in PE investment. The overseas subsidiaries of China's commercial banks, as well as China's insurance and securities companies, already have access to PE investment channels.

PE can also attract high-net-worth individuals through wealth management channels. "PE will likely split into separate markets for institutions and individuals," said one executive from a yuan fund. "The healthy development of China's equity investment market depends to a large extent on whether qualified private capital can easily access the market and enjoy a favorable environment." Greater trust between limited partners (major financiers who don't participate in management) and general partners (actual managers) is also crucial.

Local governments have also begun to establish guidance funds in order to attract more PE fund registrations. However, such assistance has proven weak thus far.

Regulatory dilemma

In most of the world, the PE process moves from the ground up. In China, success at any stage in the process, whether it be financing, investment, or exiting, depends strongly on the governing policy. Supervision and control can be complicated.

A year after the National Development and Reform Commission (NDRC) submitted its "Provisional Measures for Equity Investment Fund Management" to the State Council, nothing has been approved or implemented.

The financing success rate of the previously approved nine pilot enterprises and 20 wealth-management companies is quite low. Regulation has meanwhile challenged banks and insurance funds from investing in PE.

As long as public fund-raising and leveraged financing are kept at bay, regulators can prevent systematic risk from marbling through the greater economy. Therefore, the NDRC advocates applying looser regulations on PE than it does for most financial activities.

Moreover, only funds carrying more than 500 million yuan of financing need to keep detailed records with local governments, who are responsible for regulatory oversight. The mechanism also highlights the role of self-regulation. But even if this system is accepted as a market-oriented solution for establishing a PE fund, regulatory oversight on funds' operational risk is still a subject of continued debate.

The size matters -- most PE funds value below 100 million yuan and slip through the regulatory net. In Tianjin alone there are 272 such funds registered.

Further, risks associated with the PE industry are not mentioned whatsoever, leaving companies to rely on the subordinate regulations of agencies and local governments.

While many hope to obtain regulators' "endorsements" to ease their financing efforts, they meanwhile fear that excessive regulation will hamper growth. As a result, there have been louder calls in recent months to promote self-regulation and more moderate regulatory measures.

Obstacles ahead

The domestic PE scene is still in its early stage of development and has not yet addressed certain issues, such as problematic transfer or interests.

For instance, of the 310 small to medium-sized enterprises listed on the Shenzhen Stock Exchange, 61 received direct investments from PE prior to their listings. By late October 2009, 22 out of the 28 companies listed on the ChiNext -- China's growth board -- received PE investments prior to their listings. Based on the time of entry, PE investment to some extent has coincided with ChiNext expectations.

Data from Zero2IPO show that the first batch of 28 ChiNext enterprises' average returns were 5.76 times. In the second batch of companies, five out of eight received investment from PE or venture-capital institutions, with investment returns averaging 6.77 times. But industry experts believe that some PE investments earned tall returns during pre-IPO stages because they were tipped by local government sources or were used to funnel profits to government-backed businessmen.

Restrictions on foreign capital

The regulatory waters are beginning to clear just as more offshore PE funds enter the market. On March 1, 2010, long-awaited rules for foreign involvement in establishing partnerships in China came into force. The new rules stated that offshore PE could be used to establish domestic partnership enterprises.

However, an included article stipulated: "In accordance with its provisions, China has additional regulations regarding foreign enterprises or individuals establishing and investing in partnership enterprises in principal industries."

This "reservation clause" has left industry experts baffled about whether or not it will be possible to receive regulatory approval under the "partnership system."

Another unsolved puzzle is how to differentiate foreign capital from domestic capital. According to international practices, general partners are ordinarily required to put up 1%-5% of the capital for yuan funds. But according to Chinese law, any investment of foreign capital places the yuan fund into the "offshore fund" category, which subjects it to legal restrictions.

Also, some industries restrict or prohibit the use of foreign capital. As a result, the activities of offshore PE are limited.

On June 2, 2009, Shanghai opened the door for foreign investors to establish fund management enterprises in Pudong. Also, the local State Administration of Foreign Exchange department allowed offshore PE funds to be converted into yuan at predetermined rates, thereby eliminating the yuan financing problem for offshore PE.

An official from China's Ministry of Commerce said that the regulations leave some room to adjust today's industrial policy. For example, similar to the International Monetary Fund's stipulations on 10% voting and controlling rights, if an offshore partnership funds hold less than a 10% stake, perhaps they can be denied voting or controlling rights. Without voting power, it would be possible to discuss exempting them from the current industrial policy arrangement.

It remains to be seen if offshore PE managed yuan funds will be classified as either foreign capital or domestic capital, but general consensus suggests the former. If consensus proves right, there will be no way to dodge the investment restrictions. See this story on Caixin Online.

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